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18.9 Lease accounting
Publication date: 22 Nov 2023
us Utilities guide
ASC 980-842-45-1 through 45-2 indicates that ASC 842 specifies criteria for classification of leases and the method of accounting for each type of lease and that the classification of a lease is not affected by a regulator’s actions; a regulator cannot eliminate a liability that it did not impose. Accordingly, regulated utilities should classify leases in accordance with ASC 842. While application of ASC 980 does not impact lease classification, a regulated utility’s recovery of lease costs through rates may be different from the expense recognition and accounting for the lease under ASC 842. Specifically, as the amount of the lease payment will be included in allowable costs as rental expense for rate-making purposes, the expense recognition for a finance lease may be more akin to that of an operating lease. Application of this guidance is further discussed in the following sections below.
18.9.1 Impact of regulation on lease expense recognition
Although classification of a lease, and the nature of the expense related to a finance lease (amortization of the right-of-use asset and interest on the lease liability), are not impacted by regulation, ASC 980 provides that the timing of expense recognition should conform to the rate treatment, except with respect to newly completed plant (see UP 18.9.1.1).
The nature of the expense elements related to a finance lease (amortization of the right-of-use asset and interest on the lease liability) is not changed by the regulator's action; however, the timing of expense recognition related to the lease would be modified to conform to the rate treatment. Thus, amortization of the right-of-use asset shall be modified so that the total of interest on the lease liability and amortization of the right-of-use asset shall equal the lease expense that was allowed for rate-making purposes. For newly completed plants such regulatory treatment could result in a phase-in plan as defined in Subtopic 980-340.
Under ASC 842, the payments on a finance lease obligation are allocated between interest expense and a reduction of the lease obligation, producing a constant periodic rate of interest (i.e., interest if recognized in a pattern consistent with the interest method). In contrast, in accordance with the ASC 980-842 general guidance, the amortization of the right-of-use asset plus the interest on the lease obligation will equal the rental expense allowed by the regulator. This guidance forces the amortization of the right-of-use asset to equal the difference between the rental expense for rate purposes and the interest expense calculated in accordance with ASC 842. This results in the regulated utility recognizing expense on the finance lease similar to the expense recognition pattern for operating leases.
Example UP 18-7 illustrates the mechanics of calculating finance lease amortization and interest expense if operating lease treatment is required for regulatory purposes.
EXAMPLE UP 18-7
Regulatory lease expense recognition
Regulatory lease expense recognition
On January 1, 20X1, Rosemary Electric & Gas Company leases an asset for use in its regulated operations. Assume the following:
- The fair value at inception of the lease is $20,000.
- The lease term is five years, which is also the asset’s economic life.
- The interest rate implicit in the lease is 15.24%.
- The annual rental (due on December 31 of each year) is $6,000.
REG concludes that the lease should be classified as a finance lease in accordance with ASC 842; however, the regulator allows recovery of rental expense on a straight-line basis as payments are made. For purposes of this example, assume that the asset is not recently completed plant.
How should REG recognize its lease of the asset?
Analysis
Because the amount allowed in rates differs from the timing of expense recognition under finance lease accounting, REG should follow the guidance in ASC 980-842. The resulting income statement and balance sheet entries and amounts over the term of the lease are as follows:
Year |
Entries |
Cash |
Right-of-use asset |
Finance lease obligation |
Interest expense
|
Amortization of leased asset
|
|---|---|---|---|---|---|---|
1/1/X1
|
Record initial lease
|
$20,000 |
($20,000) |
|||
20X1
|
Lease payment
|
($6,000) |
2,952 |
$ 3,048 |
||
Amortization
|
(2,952) |
$ 2,952 |
||||
20X2
|
Lease payment
|
(6,000) |
3,402 |
2,598 |
||
Amortization
|
(3,402) |
3,402 |
||||
20X3
|
Lease payment
|
(6,000) |
3,921 |
2,079 |
||
Amortization
|
(3,921) |
3,921 |
||||
20X4
|
Lease payment
|
(6,000) |
4,518 |
1,482 |
||
Amortization
|
(4,518) |
4,518 |
||||
20X5
|
Lease payment
|
(6,000) |
5,207 |
793 |
||
Amortization
|
(5,207) |
5,207 |
||||
Total
|
($30,000) |
$0 |
$0 |
$10,000 |
$20,000 |
As illustrated in the table, because of the mechanics of this calculation, the annual amortization of the leased asset is equal to the principal reduction on the lease obligation. REG would recognize annual lease expense of $6,000. This results in differences from the ASC 842 finance lease model whereby the right-of-use asset and finance lease amortization are reduced at different rates and annual lease expense is typically higher in the earlier years of a lease, decreasing over the lease term.
18.9.1.1 Considerations for leases of newly completed plant
In general, the special lease recognition guidance for regulated utilities is not available for a finance lease of newly completed utility plant or a sale-leaseback of newly completed utility plant. The model in ASC 980-842-45-3 generally results in slower recognition of amortization expense compared with recognition under the general ASC 842 model for finance leases. This deferral of expense may result in a “phase-in plan” because allowable costs are shifted to later periods than what would be charged to expense under US GAAP applicable to entities in general. Capitalization of costs associated with a new phase-in plan is not permitted under US GAAP (see UP 18.6.1. Accordingly, for a lease of a newly completed plant, a regulated utility should recognize the leased asset amortization on a straight-line basis rather than following the method permitted under ASC 980-842. Additionally, if the regulator has not allowed a return on the leased asset or amounts being deferred for collection, this would be considered a disallowance and should be accounted for as such.
In some cases, a regulated utility may have a sale-leaseback transaction that is not part of a phase-in plan. ASC 980-842-25-1 through 25-3 as well as ASC 980-842-35-1 provide guidance for such sale-leaseback transactions.
18.9.1.2 Presentation of lease expense under ASC 842
A regulated utility should present interest expense and amortization of the right-of-use asset in a finance lease in a manner consistent with how it presents depreciation or amortization of similar assets and interest expense. Although the timing of expense recognition should conform to the rate treatment, ASC 980 does not impact the nature and presentation of the expense.
Paragraph 842-20-45-4 states that an entity is not required to classify the interest expense and amortization of the right-of-use asset in a finance lease as separate items in an income statement. However, that paragraph also states that the interest expense and the amortization of the right-of-use asset in a finance lease should be presented in a manner consistent with how the entity presents depreciation or amortization of similar assets and other interest expense. For example, the amounts of amortization of the right-of-use asset and interest on the related lease liability could each be combined with other costs and presented in a manner consistent with how the entity presents depreciation or amortization of similar assets and other interest expense. However, in that circumstance, the disclosure of total interest cost incurred, required by Subtopic 835-20, would include the interest on that lease liability, and the disclosure of the total amortization of the entity’s right-of-use assets arising under a finance lease and interest on finance lease liabilities, required by Section 842-20-50, would include amortization of that right-of-use asset and interest on that lease liability.
(a) Calculated based on the finance lease obligation multiplied by the effective interest rate. For example, in year one: $20,000 × 15.24% = $3,048. Interest expense computed under ASC 842 is not impacted by application of the ASC 980-842 guidance.
(b) Represents the difference between the annual rent expense allowed in rates and the annual interest expense calculated on the finance lease obligation. For example, in year one: $6,000 – $3,048 = $2,952. Note that a reporting entity not applying this guidance would recognize $4,000 of amortization expense annually.
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